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The Indonesian water sector: A flood of projects held back by PDAMs

Indonesia is blessed with abundant water resources, yet its people suffer from a severe shortage of potable water.

The intersection of these two facts neatly describes why Indonesia should offer a bonanza for the global water industry. Despite such promise, development activities in Indonesia's water sector remain muted, constrained by man-made conditions that above all require a national commitment to policy solutions.

Ranking fourth globally in total water resources, Indonesia's internal renewable water resources per capita are nearly two times larger than in the United States, six times larger than China's and a whopping 11 times larger than India's.

Despite this abundance, four out of five Indonesians lack access to piped water. Those few who receive it routinely boil it for fear of illness. Given the low quality and quantity of existing supply, new build private water project opportunities should be numerous. In reality, those in the planning stage are few and far between, and advance at a glacial pace.

Citizens hoping for safe water and developers seeking to invest could be forgiven for feeling like Coleridge's Ancient Mariner, becalmed at the equator and lamenting "Water, water, everywhere, nor any drop to drink."

Is under-investment due to lack of funds?

The problem is chronic under-investment. That simple statement masks the complex structural reasons for under-investment and the challenges in rectifying it. Both are essentially legal issues. Financial and operating impediments abound, but as I will argue below, successfully addressing policy failings with legal solutions must underpin any program for change.

Undoubtedly the 1990s Asian Financial Crisis is partly to blame. Indonesia's infrastructure investment rate plummeted from 7-9% GDP before the Crisis, to 1-2% GDP for the years immediately after, recovering somewhat to 3-4% GDP for the last few years. But that Crisis is nearly 20 years in the past, and Indonesia sailed through the 2008 global downturn as the only G-20 nation to record GDP growth. Awash in foreign FDI funds and resource royalties and bolstered by a sound banking system, Indonesia has had a decade to make up for under-investment in the water sector. Fading history cannot take the blame for all ills.

Anecdotal evidence suggests substantial funds wait on the sidelines, poised for investment when structural issues are fixed. What are the problems, and what is to be done?

PDAM performance – room for improvement

The primary problem is the PDAMs, regional water companies that are known in Indonesian asPerusuhaan Daerah Air Minum. These local government-owned companies comprise the bulk of a highly-fragmented water industry made up of 422 operators.

It is common to hear PDAMs criticized for their lack of capacity, suggesting that new projects are not built because PDAMS cannot plan, develop and operate them. Certainly their performance leaves much room for improvement. Most Indonesians are not served, precious water is routinely stolen and low tariffs guarantee PDAM losses.

The national average for piped water coverage stands at only 22.4%. Non-revenue water averages 33% nationally, and some PDAMs lose more than half of their product water. NRW is lost mainly through theft, including illegal connections, meter tampering and fraudulent customer classification to obtain subsidized rates. In some cases leaky pipes laid down under Dutch rule are to blame

Even were no water stolen, most PDAMs would still operate at a loss. 74% of all PDAMs sell water below its production cost. The poorest customers are charged tariff rates that are heavily subsidized. These are much lower than in some poorer countries. Tariff spreads are wide - as much as 14 times higher for the richest than the poorest customers - but in aggregate are not sufficient to achieve PDAM profitability.

To add to a PDAM's troubles, raw water sources can be unreliable, new connection rates are low and idle capacity is high. Aging, badly maintained assets are in poor condition. PDAMs do not consolidate because this would cut across local political interests.

Cash cows bled white

But pity the PDAMs. Their lack of capacity – skills, initiative and above all financial strength – in great part appears to stem from structural challenges that depress development of these attributes. PDAM failings reflect a combination of policy flaws, local political concerns and governance issues, all shaped by laws.

Chief among these is a PDAM's lack of control over its finances. Revenue is diverted away from new projects, tariffs are set to guarantee losses and input costs are often controlled by neighbours. To extend its service area to unserved citizens, a PDAM needs funds it does not internally generate, and must obtain them from a local government budget it cannot influence.

Historically, a local government owner has been permitted to declare dividends even when its PDAM was loss-making. For a local government with limited tax revenues, a PDAM is a ready source of local cash that is diverted away from PDAM investment and improvements.

Since 1962 PDAMs have been charged by law with both provision of public services and profit-seeking. This not an arcane legal distinction. Because of this dual role, the local government owner need not view its local PDAM as a public service obligation to which annual budget funds must be allocated. On the contrary, a local government may treat a PDAM as an important source of revenue. Since regional autonomy was introduced in 1999, this revenue is likely managed with less reference to national development goals.

PDAM revenues can be useful in avoiding an existential threat to local government. Many local governments have slim tax bases and few other revenue sources. Under the 2005 local government law, autonomous local government is premised on the fiscal strength sufficient to implement it. A local government with insufficient funds is at risk of being consolidated with a neighbour. In this atmosphere, PDAM revenues are tempting. It should come as no wonder that it is the PDAM that so often supports the local government, and not the other way around.

It has long been recognized that PDAM dividend payment causes under-investment in new plant, operations and maintenance, but in 40 years little has changed. 1962's local government enterprises law foresaw an 85% dividend declaration by PDAMs, 55% to local government and 30% to the workers. In 1975, the Home Affairs Minister made dividend declaration a discretionary decision of local government, allowing PDAMs to retain earnings for investment. The problem evidently continued, as it was alerted to the Indonesian government by the 1991 official report of the USAID-funded Water and Sanitation Health Project.

The practice of cash-stripping PDAMs did not fade away, and appears to have accelerated after regional autonomy began in 1999. For many newly-empowered local governments, PDAM dividends reportedly became the primary source of revenue. In 2009, the Home Affairs Minister circulated guidance that PDAMs with less than 80% service coverage should not declare dividends, allowing them to conserve funds to improve coverage. Observers question the extent to which this guidance has been followed up with monitoring, and note that central government has no enforcement powers.

When tariffs are set too low to generate profits, cash-stripping can only be sustained by infusion of external funds. Central government loans to pass through World Bank and ADB funding, bilateral funding support from the US, Japan, Australia and others, and rescheduled or forgiven loans provide the fuel to keep the PDAM dividend engine running. The PDAM effectively becomes a conduit for national and international transfers to local governments, not the destination for funding to support an essential public service.

Further PDAM challenges – the list goes on

PDAMs struggle to control input costs. Raw water sources often are not controlled by the PDAM. Under-regulated industrial development degrades the quality of raw water and pushes up the cost of treatment. In some cases increased raw water rates can be imposed on a PDAM by a neighbour without reference to the PDAM's tariffs and financial performance.

PDAM tariffs are set by social policy, not with full cost recovery in mind. Ten years ago the Home Affairs Minister provided guidelines for tariff setting, underpinned by the principle of full cost recovery plus a 10% margin. Since then, local governments fearful of political fallout still continue to avoid the tariff increases needed to meet this goal.

Progressive local politicians hoping to attract private capital for new projects may confront a PDAM unwilling to raise rates, and customers unhappy to pay higher rates. PDAMs with whom I meet recognize that the customer base has become accustomed to heavily subsidized rates. New projects may promise additional supply of superior water, but PDAMs fear customers will resist the substantial rate increases that requires.

Far from providing a revenue fix, new connections often only make matters worse. New connections are less profitable than existing ones (and in fact are routinely loss-making), as new customers are usually poor, low volume customers to whom the lowest tariffs apply.

Obtaining new customers – of questionable commercial benefit, given they are loss-making– is also challenging. Researchers have identified strong resistance among the target customer base. Unserved Indonesians like the heavily subsidized tariff, but still avoid getting connected because they object to the up-front connection cost they are charged. Amortizing the connection fee in monthly bills may be more palatable, but may feel like a tariff increase.

Indonesians lack for piped drinking water, and yet idle capacity is high. This seeming anomaly arises because tertiary distribution networks are underdeveloped, new connection rates are low and raw water supplies are constrained.

The market is fragmented, so a multitude of small players bears high operating costs. Because PDAMs are resolutely local concerns, consolidation and attendant economies of scale are unknown. Merger with a neighbour's PDAM may make financial and operational sense from the PDAM's point of view, but does not to a local government reliant on funds from a PDAM it would no longer control.

Many assets are old and in a worse condition than their age would imply. Current PDAM management often inherits accumulated problems from years of poor maintenance. Old assets that should be retired are not.

De-commissioning particularly makes sense if a proposed privately-invested project will be bankable only by modelling the old PDAM asset's customer base in its demand projections. However, political concerns make it difficult to justify demolishing old plant, even if it is worn out, delivers low quality water, is expensive to maintain and will divert demand needed to support a new plant's business case. When clean water is scarce, no local politician wants to be known for knocking down a water plant, no matter how dilapidated.

Fixing counterparty risk by finding a new counterparty

It is no surprise then that, out of 383 PDAMs across Indonesia, the Ministry of Public Works & Housing classifies only 51% of them as financially healthy. As PDAMs comprise more than 90% of the operator market and private concessionaires less than 5%, it is fair to say that half of the operator market is struggling. If the measure of health were the financial capacity to expand coverage, then clearly many more PDAMs would fail that test.

Sector-wide counterparty risk is high for investors and lenders, and stems substantially from issues that are common to a vast number of PDAMs. Fix these in a way that can be applied across Indonesia, and project opportunities may flow.

One approach would be to find another counterparty. If the PDAMs are an obstacle, why not avoid the PDAMs? This is easier than it might appear on its face. Local government policies are a large part of the problem, but local government is the solution. If a private party signs a public-private partnership (PPP) agreement with a local government, PDAM revenue stripping, PDAM losses from insufficient tariffs and high NRW levels are neatly side-stepped.

Many Indonesian cities are fiscally sound, particularly the larger ones or those located in resource-rich areas. An agreement by a local government to pay an availability charge to amortize fixed plant costs and to purchase a minimum volume of water provides an attractive proposition to investors and banks prepared to take the local government credit risk. Some will require a backstopping guaranty from the Indonesian Infrastructure Guaranty Fund, but others may be prepared to forego it.

Sadly, this solution appears to been blocked by recent legislation that restricts water extraction licenses to PDAMs and state-owned enterprises and drives business-to-business cooperation between PDAMs and private parties. These changes have thwarted new build projects that sought to avoid exposure to weak PDAM balance sheets.

PDAMs are here to stay

However, even were regulations changed again to allow direct recourse to local government, some PDAM risk would likely remain, and would need to be managed.

The recent constitutional court case overturning the 2004 Water Resources Law and the new regulations underscore that PDAMs will be expected to perform a public service with respect to drinking water, reflecting that water is a resource vital for the people's welfare.

As such, a PPP between private investors and a local government would likely feature a PDAM as the retailer of water produced by a PPP investor's project. The PDAM would likely also continue as a competing producer. Local government will have political reasons to secure a continuing role for its PDAM. PPP investors may actually prefer this arrangement, as they avoid retail responsibilities. As many water companies well know, retail customers in emerging markets are desperate for water, but not keen to pay for it.

The dual role of a PDAM as retailer and competitor would raise the risk that the PDAM may resist pressure to sell the PPP project water at prices that are higher than it currently sells its own water, and may resist an investor's request to raise its own prices to bring them in line. As a consequence, the local government's availability payment to the PPP investor very likely would exceed revenues local government can recoup from the PDAM for sale of PPP water. In effect, the problem of PDAM production costs exceeding sales revenues would be replicated with PPP water, but will have been transferred from the PDAM to the local government.

That is not necessarily a bad outcome, assuming the local government can cover the gap out of budget. The availability payment becomes a subsidy to make projects bankable and keep water cheap. However, for a PPP investor budget reliance becomes a political risk to be managed with a sound payment mechanism, most likely enshrined in local regulations. Moreover, the local government will want to lower this reliance on budget funds by closing the gap between what it pays in availability charges and what the PDAM receives for water sales. Local government should have a keen interest in improving PDAM performance. The fear is that local government be tempted to offer lower availability charges, a more expedient option that will adversely impact bankability.

Risk arises from a PDAM's continued production of water from existing facilities in competition with new PPP water. Investors, local government and the PDAM should each want to avoid PDAM sales of low quality inexpensive water in the PDAM's original service area and high quality expensive water in the new PPP service area. One can imagine one set of customers complaining that others enjoy better prices, while another set of customers complain that others enjoy superior water quality. Harmonizing prices will not help if poor quality water merely becomes more expensive. Quality differences and higher prices could give rise to broad customer dissatisfaction.

"Ranking fourth globally in total water resources, Indonesia's internal renewable water resources per capita are nearly two times larger than in the United States."

These risks can be mitigated by encouraging the PDAM to charge and collect more for all water and to harmonize prices for PPP water and PDAM water. To aid the PDAM in this effort, the PPP investor will want to offer assistance to the PDAM to improve the quality of water from existing PDAM plant, repair and build out downstream facilities, aggressively address NRW reduction and provide training.

Better PDAMs through better policy

Even if allowed, directly contracting with local government is a short term solution, and has its limits. Availability charges have long been permitted, but last year received an explicit endorsement in new regulations. However, availability charges are attractive only as long as the payer has suitable financial wherewithal.

Many Indonesian cities do, but that list will not include more than a small fraction of the service areas covered nationally by the PDAMs. Moreover, with commodities prices depressed, and other infrastructure demands placed on local government balance sheets, municipal funding will become tighter. Side-stepping the PDAMs would be a limited near-term solution.

This leaves the choice of transacting with the PDAMs despite their current limitations, or fixing their problems. If PDAMs are taken essentially as they are, the Indonesian Infrastructure Guarantee Fund and other forms of government support can be used to shore up the PDAMs sufficient for PPP investors and lenders to take their counterparty risk. Several proposed PPPs will take this approach. However, there are balance sheet limits to, and competing demands on, IIGF and other government supports. From Indonesia's perspective, improving the PDAMs is clearly the preferred longer-term solution. How best to do so?

For a start, local government should be prohibited from forcing PDAM's to pay dividends unless the PDAM's revenues cover its costs of production plus a margin, and the PDAM service area coverage achieves defined, aspirational targets that ratchet over time. Dividends should be payable only after full cost recovery, and then only out of profits. In short, bolster PDAM balance sheets by putting an end to local government's revenue stripping.

Central government does not own or control the PDAMs, but can amend the law under which they are constituted, the 1962 Law on Local Government Enterprises. The central government should consider imposing on PDAMs an obligation to prioritize public service, met first out of PDAM revenues and then from local government's budget. Tariff policy can also by law be made subject to a full cost recovery principle, and not merely guided to this goal by a Minister's recommendation.

The immediate prospects for these legal changes are not bright. These are ideas that, in my experience, rarely feature in discussions more likely to focus on seeking project-specific solutions. If implemented, local government would lose a source of funding, shifting the burden of financing local government further onto the central government. Absent dramatically improved tax collection efforts, increased sovereign borrowings, or both, the central government is not likely to want to shoulder that burden.

Like the PDAMs, state electricity utility PLN also suffers from costs of production that exceed its tariff revenues. In PLN's case, the central government pays a "public service obligation" subsidy to make up the shortfall, thus making PLN bankable. To implement a similar PSO system for nearly 400 PDAMs would be a major challenge that would require a complete overhaul of control or ownership to assure that local governments did not simply strip that national subsidy just as they currently strip PDAM water sales revenues.

The social goals driving tariff policy deserve a re-think. With tariffs set so low, current tariff policies restrict revenues and indirectly restrict investment in new water projects. Low tariffs clearly do not help the poor if they result in revenues so low that PDAMs cannot build and properly maintain treatment plants and tertiary distribution systems that produce high quality, potable water.

A complete overhaul of tariff policy, starting with central government authority for rate setting, is a massive undertaking likely to encounter public opposition. If coupled with robust NRW reduction programmes, tariff reform offers an obvious path to securing more revenue from water sales by ending generous end-user subsidies that do more harm than good.

Muddling through

The future is likely to present a state of affairs that is better than it could be, but not as good as it should be.

Power and transportation appear to be the central government's policy priorities at the moment. Water is a local issue held hostage by local PDAM ownership and local fiscal and social interests. All agree that piped safe drinking water is important, but with groundwater wells and other water resources available to unserved citizens, it will take a progressive, forward-thinking local politician to make water a priority.

So what is better than it could be? In the near term we may see a modest flow of projects driven by PDAM/private sector cooperation, perhaps receiving IIGF or other central government support. Given the paucity of PPP water projects in Indonesia, this would be a step forward.

And what is not as good as it should be? Regulatory changes to bolster PDAM balances sheets – such as increasing tariffs and ending inappropriate dividends– are, at best, medium term goals. The new water regulations that addressed the recent revocation of the 2004 Water Resources Law was a lost opportunity, a patch that clarified the authority of state parties that can act as PPP government contracting agencies, rather than an initiative to address basic PDAM policy woes.

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